chapter 5 time value of money
DESCRIPTION
2012 pearson education 13th edition lawrence j. gitman chad j. zutterTRANSCRIPT
Copyright © 2012 Pearson Education
Chapter 5
Time Value of Money
© 2012 Pearson Education 5-2
Figure 5.2 Compounding and Discounting
© 2012 Pearson Education 5-3
Figure 5.3 Calculator Keys
© 2012 Pearson Education 5-4
Future Value of a Single Amount
• Future value is the value at a given future date of an amount placed on deposit today and earning interest at a specified rate. Found by applying compound interest over a specified period of time.
• Compound interest is interest that is earned on a given deposit and has become part of the principal at the end of a specified period.
• Principal is the amount of money on which interest is paid.
© 2012 Pearson Education 5-5
Future Value of a Single Amount: The Equation for Future Value
• We use the following notation for the various inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this rate.)
– n = number of periods (typically years) that the money is left on deposit
• The general equation for the future value at the end of period n is
FVn = PV (1 + r)n
© 2012 Pearson Education 5-6
Future Value of a Single Amount: The Equation for Future Value
Jane Farber places $800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of five years.
This analysis can be depicted on a time line as follows:
FV5 = $800 (1 + 0.06)5 = $800 (1.33823) = $1,070.58
© 2012 Pearson Education 5-7
Present Value of a Single Amount
• Present value is the current dollar value of a future amount—the amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount.
• It is based on the idea that a dollar today is worth more than a dollar tomorrow.
• Discounting cash flows is the process of finding present values; the inverse of compounding interest.
• The discount rate is often also referred to as the opportunity cost, the discount rate, the required return, or the cost of capital.
© 2012 Pearson Education 5-8
Personal Finance Example
Paul Shorter has an opportunity to receive $300 one year from now. If he can earn 6% on his investments, what is the most he should pay now for this opportunity?
PV (1 + 0.06) = $300
PV = $300/(1 + 0.06) = $283.02
© 2012 Pearson Education 5-9
Present Value of a Single Amount: The Equation for Present Value
The present value, PV, of some future amount, FVn, to be received n periods from now, assuming an interest rate (or opportunity cost) of r, is calculated as follows:
© 2012 Pearson Education 5-10
Present Value of a Single Amount: The Equation for Future Value
Pam Valenti wishes to find the present value of $1,700 that will be received 8 years from now. Pam’s opportunity cost is 8%.
This analysis can be depicted on a time line as follows:
PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
© 2012 Pearson Education 5-11
Figure 5.5 Present Value Relationship